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Banking

Bond Outlook by bridport & cie, February 22 2012

To explain the lack of bid liquidity in European corporate bond markets, we hypothesis the existence of a yield barrier below which buyers refuse to go.

In our last two editions of this Weekly, we have alluded to the difficulties in explaining the present behavior of bond markets. In Europe, we have rarely encountered such illiquidity on the offer side (US markets are more liquid). The ease with which corporate bonds can be sold has its corollary in that there is a massive shortage of bonds for buying. Conventional economic theory tells us that there is always a price at which supply and demand equalise. Yet in the current environment, there is often simply no offer at all. We suspect that this reflects, to a large extent, issues with market making: capital is constrained because of imminent, but still difficult to quantify, Greek haircuts, a reduction in the number of true market making firms, and a general antipathy to risk in an uncertain economic environment.

 

Nevertheless, there is a fundamental shift happening in the bond markets in their own right. That “something” is growing disenchantment with over-indebted governments in favour of corporate bonds, so that the normal spreads of corporate issues over governments have narrowed, or even disappeared.

 

There may be, however, a barrier below which bond buyers are not prepared to go in accepting low yields. Just where that limit lies is hard to define: recently, Swiss government bonds had negative yields – that seems either irrational, or is indicative of considerable concern in that investors are willing to accept a guaranteed loss in favour of perceived capital security -- and when bond yields in other major currencies are less than 3%, the real return is scarcely above 1%. There may indeed be a price at which supply will rise to meet demand, but that price lies above the invisible yield barrier against which institutional investors are now bumping.

 

Even the traditional inverse correlation between equity and fixed-income markets has disappeared. Prices are high in both markets in parallel. Yet there is a sense of unreality everywhere. The Greek bail-out has gone through, but amid warnings that this is not the last chapter (private sector bondholders, who will be called upon to support further debt issuance in the future, are upset at the level of proposed haircuts, and may not be so easily coerced into giving up their enshrined rights by threats of Collective Action Clauses by the Greek government). Low inflation looks imbedded, but there are continued concerns about commodity prices and the wall of money expecting the reversal of QE. Hovering over stock markets is anaemic economic growth, as deleveraging continues year after year, and on which governments, especially the US government, are well behind the private sector. The reader might retort that financial markets always carry risk. This is absolutely true, but what is so remarkable is that the rewards being offered for that risk are now so modest.

 

At a time when oil prices are climbing, along with the tensions created by Iran and Syria, we happily follow the lead given by Martin Wolf in the FT about the positive impact of natural gas supply greatly increasing through “fracking” technology. Always assuming the environmental problems are resolved, abundant natural gas will be a real boon to both Western and Chinese economies, improving the trade balance for the West and loosening (although not freeing) the grip of the Mideast oil suppliers on the world economy.

 

Our next Weekly will be in the hands of Caroline while its regular author samples the economic realities of Toronto and New York.

 


Macro Focus

USA: the cost of living rose less than forecast in January, the CPI increasing 0.20% following no change in the prior month. Factory production increased by 0.70% after a revised 1.50% in December

 

Europe: the European economy contracted less than forecast in Q4 on better than expected performance from Germany and France, GDP overall fell 0.30% from Q3 with the French economy even expanding 0.20% in Q4. In December construction output rose 0.30% from November the most in five months; strength in Spain helped offset declines from Germany and Portugal

 

Greece: the country reached a deal with private creditors, leading to a second bailout of €130 bln from European governments. Private investors will give up 53.50% of principal in exchange for 15% in a EFSF bill with a maturity of 24 months and 31.50% in a new 30’year bond with a coupon of 2% for the first 3 years, 3% for the next 5 years and 4.30% thereafter. Investors will also receive a sweetener in the form of a GDP linked note. According to an official, Euro-area central banks will swap the Greek bonds in their investment portfolios for similar securities to avoid enforced losses during a debt restructuring. The swap will mean that central banks holdings in bonds will be immune to collective action clauses, or CACs, ensuring they do not incur any losses when the private-sector debt is written-down

 

Spain: the country’s debt load is set to double from where it was when Europe’s sovereign debt crisis began. Spain went into the crisis with public debt of 40% of GDP, compared with an average ratio of 70% in the euro region. The European Commission forecasts Spain’s debt load will climb to 78% of GDP in 2013, compared with a euro-area average that will have risen to 91%.

 

Germany: the Bundesbank stated that the economic outlook for Germany has improved perceptibly despite the on-going sovereign crisis. However they remained mindful that external factors would weigh on production through Q1

 

UK: Britain posted the largest budget surplus in four years in January, revenue exceeding spending by £7.75 bln, compared with a surplus of £5.2 bln a year earlier. Retail sales rose for a second month. Sales including fuel rose 0.90% from December, when they rose 0.60%. Consumer confidence rose in January to the highest level in five months, according to Nationwide Building Society, from an index of sentiment of 38 in December to 47. Jobless claims increased to 1.6 million, the highest since January 2010, and unemployment held at the highest rate for 16 years in Q4 as the economy contracted

 

BoE: Mervyn King described the likely path of the recovery as slow and uncertain and expects swings between growth and contraction throughout 2012. The biggest risk to the recovery remains developments in the euro area, specifically concerns about the indebtedness and competitiveness of some member countries

 

Switzerland: investor confidence rose to the highest in nine months in February, the ZEW index of investor and analyst expectations rose from -50.1 in January to 21.2

 

China: the central bank of China is to make more cuts to banks’ reserve requirements to encourage lending and help sustain economic growth as the housing market cools and Europe’s sovereign-debt crisis weighs on exports. The reserve requirement will fall 0.50% from February 24th

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